The Fed's in Play: What's in Store?

Highlights

A series of strong jobs reports have lowered the unemployment rate to 5.5%, which could prompt the Fed to begin normalizing interest rates, possibly in the June-September time frame. Nonetheless, the Fed has considerable leeway, because inflation measures are still well below the Fed's 2% target and wage pressures are absent.

Once the Fed makes its move, the markets will focus on the path of future interest rate hikes. The bond market is pricing in a more gradual path than what FOMC participants envision, with the fed funds rate reaching 1.5% by year-end 2016 compared with 2.5% based on FOMC members.

My own assessment is the Fed is likely to proceed very cautiously initially, but I expect the funds rate to peak at a higher level than what is priced into the bond market.

Strong Jobs Reports Could Bring the Fed into Play

February's surge in non-farm payrolls of 295,000 was the latest in a series of strong reports, in which job gains averaged 288,000 in the last three months and more than 200,000 a month for the last 12 months. It lowered the unemployment rate to 5.5%, which is the upper end of the range that FOMC participants consider to be full employment. This is the strongest jobs growth since the late 1990s, and some observers believe it increases the likelihood that the Fed will begin raising rates around midyear.

Previously, Fed Chair Janet Yellen indicated in her Humphrey Hawkins testimony that the FOMC was likely to drop language about being "patient" in raising interest rates at the upcoming meeting. However, she also stated that Fed officials have to be "reasonably confident that inflation will move back over the medium term to our 2 percent objective." This gives the Fed considerable room to maneuver, as headline and core inflation are well below this level, and wage increase has been moderate.

Nonetheless, should recent trends on the economy and jobs continue while oil prices stabilize, the Fed could initiate rate hikes as early as June, but more likely in the second half of this year.

Gradual Pace of Fed Tightening

Whichever start date the Fed selects, it is expected to proceed gradually in raising rates in the balance of this year and into 2016. However, there is a noteworthy difference between expectations of FOMC members and what is priced into the bond market. The median forecast of FOMC members, for example, calls for the funds rate to end this year and next at 1-1/8% and 2.5%, respectively. By comparison, the bond market is pricing in more gradual rate hikes – 0.65 % and 1.5%, respectively.

The difference in views partly reflects different forecasts for the economy, with Fed officials more upbeat about growth prospects than market participants. But there are other considerations, as well. Most notably, the leadership of the Fed –Janet Yellen and Bill Dudley – is more dovish than some of the district presidents. Another consideration is that the Fed does not want to unsettle the bond market, as occurred in mid-2013, when the Fed announced it was considering phasing down its quantitative easing program.

The choice the Fed faces has been characterized as deciding between one of two options: (i) begin to raise rates soon and do so very gradually; or (ii) delay raising rates (possibly until 2016) and raise rates more rapidly thereafter. My own take is that there is a third option – namely, at each FOMC meeting or on a quarterly basis, the Fed can make it clear that it will not necessarily make regular rate hikes and that each rate move data dependent. While this would increase near-term volatility of the bond market, it would avoid pre-committing the Fed to act when there is considerable uncertainty about the outlook.

The Terminal Fed Funds Rate

Another key issue is where the funds rate is ultimately headed. Prior to the 2008 Financial Crisis, the real (or inflation-adjusted) funds rate averaged between 2.0%-2.5%. Assuming the Fed hits its 2% inflation target, therefore, it would be reasonable to expect the funds rate to rise somewhere between 4.0% to 4.5%. Following the Financial Crisis, however, it is generally assumed the trend growth rate for the U.S. economy is lower than before due to diminished growth of productivity. If so, the long-term equilibrium funds rate should be lower than before.

In this regard, a recent study by four prominent economists concludes that the real funds rate has probably declined from 2.0% to 1.75%.1 If so, it would imply a long-term equilibrium funds rate of 3.75%, assuming the Fed's 2% inflation target is reached. By comparison, bond market participants are pricing in a lower long-term funds rate, which is projected to peak at about 2.5%. This expectation is more in line with economists, such as Lawrence Summers and Paul Krugman, who are concerned about "secular stagnation" – or persistent low economic growth.

My own take is that the bond market's long-term projection is too low, as it presumes little or no growth in the U.S. economy: I believe trend growth is somewhere between 2%-2.5%, or between three quarters to a full percentage point below its historic trend, but well above what those in the "secular stagnation" camp believe.

Implications for U.S. Bond Yields

One of the biggest surprises last year was the 100 basis point decline in U.S. bond yields despite an improving U.S. economy. It mainly reflected the tug of declining bond yields abroad and lower inflation that was linked to plummeting oil prices. More recently, however, the U.S. economy has continued to gain traction while the economies of Europe and Japan are growing again, and oil prices have stabilized. This has been accompanied by a rebound in 10-year Treasury yields to 2.1%, or roughly 40 basis points above its lows. If these trends persist and the Fed begins to raise rates in the second half of this year, I foresee the yield on the 10-year Treasury reaching 2.5%-2.75% this year. Over the next few years my call is that the funds rate will approach 3.5%-4%. If so, it would be consistent with a yield for the 10-year Treasury in the vicinity of 4%-4.5%, assuming a term premium of 50 basis points over the funds rate.

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